AMERICAN COLLEGE OF REAL ESTATE LAWYERS SPRING 2001 PROGRAM Shopping Centers - Current Issues And Challenges March 29-31, 2001 Williamsburg, Virginia OPERATIONS COVENANT By Joel R. Hall The Gap, Inc. San Francisco, California (D Joel R. Hall All Rights Reserved PHL_A #1457546 v1 WORD97
TABLE OF CONTENTS Page 4.00 OPERATIONS COVENANT... 2 4.01 Covenant to Operate/Express v. Implied... 2 4.02 The Obligation: General Obligation v. Specific Hours Requirement... 2 4.03 The Covenant to Operate From a Landlord's Perspective... 3 4.04 Modifying the Covenant to Operate From a Tenant's Perspective... 4 4.05 NEGOTIATING FOR A COTENANCY REQUIREMENT... 5 PHL_A #1457546 v1 WORD97 -i-
4.00 OPERATIONS COVENANT 4.01 Covenant to Operate/Express v. Implied. Shopping center lease forms, as they first developed, generally did not contain an express covenant of the tenant to operate from his premises. While many of these leases did include percentage rent clauses, few contained an express covenant of the tenant to operate so as to ensure that the tenant would be generating sales. There is a substantial body of case law wherein the covenant of a tenant to operate has been implied by the courts from a variety of factors including the presence of other operating requirements in the lease 1 or the adequacy of the minimum rent being paid as compared to the percentage rent provisions. This last factor - the adequacy of rent - has been the most influential in determining whether a continuous operations covenant will be implied. If the court found that the minimum rent was nominal, it often concluded that the parties intended that the landlord also rely on the percentage rent generated from tenant's sales to ensure an adequate rental return from the premises. Conversely, if the minimum rent was found to have been adequate -- when viewed at the time of lease execution, not at the time of the lawsuit-- then no covenant would be implied, the court refusing to protect the landlord from its own imprudence in failing to include an express covenant to operate or providing for rent increases over the term. In modern shopping center leasing practice landlords rely principally upon the express covenant to support the tenant's obligation to operate the store and produce percentage rent. 4.02 The Obligation: General Obligation v. Specific Hours Requirement. As shopping center leases evolved, they began to include a general covenant of the tenant to operate from the premises such as the following: Figure 4-1 General Covenant to Operate Tenant agrees to continuously and uninterruptedly occupy and use during the term the entire Premises for the Permitted Use and to conduct Tenant's business therein in a reputable manner. A slightly more specific clause, like the one which follows, was also found in early leases (including the ancestral version of the International Council of Shopping Centers' standard form) and referred to hours of operation in a general way: 1 E.g., provisions requiring a tenant to keep the store continually stocked and staffed, a covenant to use his best efforts to maximize sales and a requirement that the tenant staff the store with a sufficient number of employees. PHL_A #1457546 v1 WORD97
Figure 4-2 General Reference to Hours of Operation Tenant agrees to remain open for business during the usual days and hours for such business as are customary in the vicinity of the Shopping Center. Today, most shopping center leases include rather specific requirements, with the right of the landlord to change hours from time to time, such as the following clause: Figure 4-3 Specific Reference to Hours of Operation Tenant will operate Monday through Saturday from 10:00 A.M. until 9:00 P.M., on Sundays from 12:00 Noon until 6:00 P.M. or during such other days and hours as are designated by Landlord. As a general rule, as each form of the covenant evolved in leasing practice it did not replace the former one but rather was merely added to it. Now one can find all three versions in one lease, recited one right after another. The reason for this, aside from the pull of tradition, was the theory that if for some reason the other stores were not operating in a uniform fashion - e.g., if the department stores or satellite stores operated every day but closed early or at different times - then the Landlord could still rely on clauses like Figure 4-2 to retain some residual, general (and vague) obligation to operate for at least some period of time, for example, until 3:00 P.M. when most of the tenants were still open. Thus, those landlords willing to include a cotenancy requirement in their lease would write them in the following form: Figure 4-4 Reference to Operation of Other Tenants Tenant will operate during such days and hours that the ABC Department Store plus tenants occupying at least seventy-rive percent (75%) of the GLA of the Shopping Center are open and operating. (Emphasis added) 4.03 The Covenant to Operate From a Landlord's Perspective 2 A fundamental, philosophical issue regarding sharing of risks emerges in every cotenancy clause negotiation. Has a tenant entered into a lease for space in the shopping center with an iron-clad guarantee of full operation of all major department stores and all other tenants as a condition to such tenant's 2 Portion of this 4.03, From a Landlord s Perspective reprinted with permission of Mark S. Hennigh, Esq., Greene, Radowshy, Maloney & Share, San Francisco, CA and Elizabeth H. Belkin, Esq., Rudnick & Wolfe, Chicago, ILL. PHL_A #1457546 v1 WORD97-3-
obligation to operate, or, has the tenant entered into a lease for the right to operate within a shopping center market created by the landlord but with the attendant risks of discontinued operation of major department stores and/or certain other retail tenants? It is important to note that the success or failure of major department stores and other retailers within the shopping center is often not a function of the operation of the specific shopping center, but rather of the marketplace generally, and the ability of the department stores and satellite stores to operate within the marketplace. From a landlord's perspective the risk of department stores or other retailers closing is, therefore, a marketplace risk and not necessarily a developer risk which should be borne exclusively by the owner of the shopping center. From a landlord's perspective, the chain retailers most capable of negotiating strong cotenancy clauses are also those retailers who are often financially stronger than the owner of the shopping center itself and are capable of analyzing the demographics of any retail market and the trends within that market. Therefore, their obligation to operate should not be dependent (or co-dependant) upon the continued operation of their neighbors. Tenants often highlight the hundreds of thousands of dollars invested by them in improvements and merchandise. The landlord, in response, may point to tens and hundreds of millions of dollars expended in development of the shopping center. Both the landlord and the tenant share the desire to see the shopping center become a successful development. From where a landlord sits, however, to ask a tenant to risk ten or a hundred thousand dollars in a shared risk with the landlord's ten or hundred million dollar risk does not appear unreasonable. 4.04 Modifying the Covenant to Operate From a Tenant's Perspective. The argument that the closure of a department store is a "marketplace risk" rather than a developer risk is based upon a rather feeble theory. When the landlord induces a tenant into a center, it is the retail environment created by the center and the department stores that the tenant has responded to, with the demographics of the surrounding marketplace being an extremely important but secondary influence. If all a tenant were concerned about was the surrounding marketplace, it would not need to go into the landlord's shopping center. It could find a street location in that marketplace with only the minimum rent and taxes to worry about -- no percentage rent, no CAM charges, no central FIVAC, no merchant's association, no kiosks, no relocation clause, no intrusion by columns or conduits, no use clause, no tradename restriction, a free right to assign and no operating covenant. It is the retail environment created by the shopping center that a tenant bargains for (and that the Landlord held out to the Tenant), not merely the marketplace in which it is located. For the satellite tenant in an enclosed regional mall, an operating covenant for the entire term of the lease is a fact of life. Nonetheless, in order to increase his flexibility and reduce his downside risk, it is essential for the tenant to modify the operating clause with a cotenancy provision. After all, the Landlord enticed the tenant into his mall by projecting an image of a community of quality named retailers. 3 Although the boilerplate of his lease (and the site plan at the back of the lease) will disclaim any inference of such an inducement. 3 Although the boilerplate of his lease (and the site plan at the back of the lease) will disclaim any inference of such an inducement. PHL_A #1457546 v1 WORD97-4-
4.05 NEGOTIATING FOR A COTENANCY REQUIREMENT Negotiating For A Cotenancy Requirement. Assume that the business representatives of the landlord and tenant have agreed that the tenant's operating requirement is to be tied to a department store and a certain percentage of mall tenants. A landlord will sometimes submit a clause like the following: Figure 4-5 Tenant's Requirement to Operate - Cotenancy Tenant shall be required to operate during designated days or hours provided that the ABC department store (or its successor) is required to operate and 75% of the tenants (including Tenant) are required by-their leases to be open during such days and hours. (Emphasis added) To the tenant, such a clause is a travesty of the agreement between the business people and a mockery of the tenant. 4 From a tenant's perspective, such a provision should be modified in accordance with the following principles. Elements of The Cotenancy Clause Discussion 4.05-1. The Department Stores and Their Successors. The tenant should not permit the anchors to be designated merely as ABC or its successors or replacement or the occupant of the space initially intended to be occupied by ABC ; this is totally unacceptable from a tenant's point of view. The principal and procuring cause in inducing the tenant into the center is who the anchors are and where he is in relation to them. Thus if ABC is a department store of known and desired quality-- exuding a high drawing power -- then, replacing ABC with a lower-end operator lacking the same drawing power for the same type of customer frustrates the tenant's legitimate business expectations. To make matters worse, most landlords have departed from the use of the word "department stores" in their lease forms and now attempt to create classes of "Major Tenants" or "Anchor Stores" who are merely large space users and may not even be department stores at all. Such "Anchor Stores" are simply defined in terms of square footage without any name recognition tied to the definition but they are nevertheless intended by the landlords to satisfy the operating cotenancy requirements. Some leases define such stores as small as 15,000 or 20,000 square feet; they may even presume to call them "department stores"! 5 In such a case, a satellite tenant may find that his operating covenant is tied to the sporting goods store, the toy store or the furniture store rather than to a Penney's or Macy's. In order to protect himself the tenant must insist that the concept of "anchor store" be specified to mean a "department store" and that the 4 " No poet ever interpreted nature as freely as a lawyer interprets truth." Jean Giradoux 5 One developer has created two classes of special retailer: any store in excess of 25,000 square feet is called a Major and any store in excess of 15,000 square feet being labeled a Junior Major (!), presumably for purposes of CAM and taxes. PHL_A #1457546 v1 WORD97-5-
term "department store" in turn be carefully defined to encompass only those retail operations commonly accepted as "true" department stores. The definition of a "true" department store is comprehensively discussed in Appendix - I of these materials. "I Can't Control The Department Stores Many landlords have resisted even including the department stores as part of a cotenancy requirement on the grounds that department stores often have only a limited operating covenant in terms of years or sometimes none at all; therefore, they cannot control them. This is particularly true where the department store owns its own parcel, having purchased it from the landlord. However, when the tenant approved the deal, he was buying into the concept of a synergistic retail environment, anchored by department stores. In fact, the presence of specifically named department stores was one of the key selling points the landlord used to induce the tenant into the center. The landlord cannot now turn around and completely discount those considerations as unimportant to the tenant. If the landlord chooses to parcel out portions of the tract to the department stores, fine, but he cannot then pretend or ask the tenant to pretend that they no longer exist for purposes of the lease. The issue is not whether the landlord is at "fault" or whether he can control the department stores; the only thing that matters to the tenant is whether the named department store is open or not. 4.05-2. Actually Open vs. Required to be Open. Predicating a tenant's requirement to be open on the majors being required to be open rather than actually being open is still a position taken by many landlords. However, to state the condition in terms of being required to be open is discounting the tenant's prime motivation. The presence or absence of an operating covenant in the department store's lease or REA is not the controlling factor for the tenant. Again, the only thing that matters to him is: "Is the department store open or not?" When applied to the satellite stores, the "required to be open" test is especially problematic. It is unlikely that the condition could ever fail because every satellite lease contains an operations covenant, even if it is coupled with a cotenancy provision. Indeed, if these tenants went dark in violation of their leases, the landlord would still have met the test simply because there was a clause in their leases requiring them (in some form or another) to be open, whether or not they were actually open. The only thing that matters to the tenant is how many other retailers are actually open, regardless of what their leases say. That is what the tenant bargained for when he signed the lease. Landlords frequently offer the tenant a covenant that the landlord will use all reasonable efforts to enforce the operating clauses of those other leases while insisting that the tenant accept the "required to be open" language. From a tenant's perspective such efforts are not especially helpful because specific performance is difficult to obtain and termination of the other fellow's lease does not increase the number of other stores that are open. 4.05-3. Percentage of the Satellite Cotenancy. The phrase 75% of the tenants (including Tenant) are open... in Figure 4-5 is a problem for the tenant because if the shopping center is only 80% leased then the landlord's requirement is diluted to merely 75% of 80% or 60%. PHL_A #1457546 v1 WORD97-6-
This provision would allow the landlord not to require an operating covenant in 40% of his leases while still requiring the tenant to operate. The cotenancy requirements must be tied to a percentage of the gross leasable area of the center being open, not just a percentage of the tenants the landlord happens to have. Is The Premises Included In The Count?. Another point sometimes injected by the landlord's counsel is whether the tenant or the premises should be included in the count. For example, if the total satellite store gross leasable area ("GLA") was 100,000 square feet and the tenant occupied 5,000 square feet, the landlord would argue that the 75,000 square feet (75% of 100,000) includes the tenant's store itself as being counted towards meeting that total. This means that the landlord only has to have 70,000 square feet of other space open - 70% of the 100,000 square foot total GLA - in order to require the tenant to open. From a tenant's perspective, he is interested in what the other stores are doing before he himself can be required to be open; his own store should not be included. Often the tenant will write the clause as follows: 75% of the total gross leasable area of the Shopping Center (which shall be made up of stores other than the Premises). What the tenant intends is that 75,000 square feet of other stores be open before tenant is require to be open. And that 75,000 square feet is calculated as 75% of the total GLA of the center, even if that total includes the area of the Premises. However, the landlord complains that such an interpretation raises the cotenancy requirement to 80% (75,000 plus the 5,000 square foot Premises = 80,000 square feet), although the logic of adding in the area of the Premises is difficult to follow since we are supposed to be talking about what the other stores are doing. The landlord would interpret that phrase to mean that (1) first, you subtract the tenant's 5,000 square feet from 100,000 = 95,000 square feet, and then (2) you take 75% of 95,000 = 71,250 square feet of "other" GLA. Thus, 71,250 of other satellite GLA must be open to require tenant to be open. This is almost the same result as the Landlord's original position of simply including the tenant's premises in the count (70,000 vs. 71,250). Admittedly, the phrase is open to two interpretations despite the flaw in the landlord's logic. To make the tenant's intention perfectly clear, the following phrase should be used: Figure 4-6... provided that the ABC Department Store plus stores other than the Premises and representing seventy-five percent (75%) of the total GLA of the Shopping Center (which calculation of total GLA includes the GLA of the Premises but excludes the GLA of the Department Stores) are operating during such designated days and hours. 4.05-4. Closing Completely or Maintaining Limited Hours? Figure 4-4, discussed above, provides as follows: Tenant's Obligation Fluctuating PHL_A #1457546 v1 WORD97-7-
With The Level of Open Stores (Figure 4-4 Revisited) Tenant will operate during such days and hours that the ABC Department Store plus tenants occupying at least seventy-five percent (75%) of the GLA of the Shopping Center are open and operating. (Emphasis added) Clearly, a tenant does not bargain for an obligation to be open simply because most of the other tenants are open during some days and hours, if those days and hours don't make any sense for the tenant - e.g. 11:00 a.m. to 3:00 p.m. Nor does the tenant bargain for the privilege of being allowed to close early (e.g. 3:00 PM) simply because the landlord could only maintain the cotenancy requirement up until that time. From a tenant's perspective, his obligation to open for business at all, as well as his obligation to operate during specified days and hours, should be treated as one, directly tied to the cotenancy requirements. Thus, a tenant seeking to modify the covenant to operate might draft the opening lines in the following manner: Figure 4-7 Tenant's Obligation to Open Excused Tenant shall not be required to open the Premises for business at all nor to operate during designated days and hours unless the ABC Department Store-p@Fu-s stores other than the Premises and representing seventy-five percent (75%) of the total GLA of the Shopping Center (which total GLA includes the GLA of the Premises but excludes the GLA of the Department Stores) are operating during such designated days and hours." In this way the tenant has protected himself against having to operate during days or hours that are not right for him simply because the cotenancy requirements are being maintained during those times. But there is one more factor to consider. The landlord has the right to redefine the "designated days and hours" to suit his purposes. Suppose, for example, that because many stores were closing early the landlord redefined store hours to be "10:00 a.m. to 4:30 p.m. because that is the period that the landlord managed to meet the operating cotenancy requirements. Or he simply redefined the "designated days and hours" as those days and hours that the department stores and a majority of the satellite stores were open. These may not be hours that the tenant would want to maintain. Any sales that he might experience during this short day would be outweighed by the expense of hiring staff, allocating inventory and running utilities; it may be cheaper simply to not open at all. Alternatively, the landlord may want to designate later hours during the Holiday season or to hold occasional "Midnight Madness" sales. It must be solely at the tenant's option to operate during these additional hours which exceed his accepted core hours. To deal with this possibility, the following clause must be added to Figure 4-7: PHL_A #1457546 v1 WORD97-8-
Figure 4-8 Limiting Changes of Specific Hours Notwithstanding the foregoing and regardless of the days and hours of operation that the Landlord may designate or whether the Operating Requirements are being met, the Tenant shall not be required to: (i) open earlier than 10:00 a.m. or later than 11:00 a.m. Monday through Saturday, or to open earlier than 12:00 noon on Sunday; (ii) remain open later than 9:30 p.m. Monday through Saturday or 6:00 p.m. on Sunday; (iii) to be open at all if tenant would thus be required to be open for business less than eight hours per day Mondays through Saturdays or less than five hours on Sunday. Right of Tenant to Stay Open During Additional Hours. Now that the tenant has made the point that he is not required to be open during additional hours, he will want to provide for the right to open during extra hours if other tenants in the mall are open. In negotiating this point the landlord may wish to exclude tenants such as theaters or restaurants and permit tenant to open only if other regular retailers are open after hours. He may also want the tenant to pay its share of the costs of operating the shopping center during those additional hours, allocated among the square footage of those tenants that are actually participating. This compromise is perfectly OK. 4.05-5. Exemption For Inventory and Remodeling. There should also be provision for temporary closings due to inventory and remodeling or restoration in the case of casualty or condemnation. Although this exception would seem to be obvious, there have been eyebrows raised in a few malls when the tenant did close; so it is now prudent to provide for this in the lease. The landlord will want limits put on these permitted closures; this is appropriate provided the tenant has given himself sufficient time to accomplish these objectives. 4.05-6. Requirement to Open On National Holidays. Most retailers close on certain special national holidays like Easter, Thanksgiving and Christmas. This is rarely a problem. However, what has become an increasing problem for some tenants is the growing tendency of malls to require New Year's Day openings because the anchor chooses to be open on that day. Many retailers guarantee this day off to their employees. The tenant should specify his needs in the lease to avoid any doubt. A provision like the following would work: PHL_A #1457546 v1 WORD97-9-
Figure 4-9 Ability to Close on Holidays Notwithstanding the foregoing and whether or not the foregoing requirements are being met, in no event may the "designated days and hours" of the Shopping Center as determined by Landlord require Tenant: (a) (b) [see Figure 4-8 above] to be open Easter Sunday, Thanksgiving Day, Christmas Day or New Years Day;... 4.05-7. Requirement to Open on Sunday. There are still a few local jurisdictions that limit Sunday openings. Even in such jurisdictions, however, some landlord lease forms may require the tenant to open on Sundays (i) while the statute is being contested or (ii) if only a small penalty is involved. This is not acceptable as the landlord may not make this decision for the tenant. Further, the fact that a fine may be small is of no consolation to a tenant (or its store manager) who may end up with a misdemeanor conviction on his or her record. If presented with such a clause, a tenant should add the following: Figure 4-10 Operating Requirement Not to Violate Laws Notwithstanding the foregoing and whether or not the foregoing requirements are being met, in no event may the "designated days and hours" of the Shopping Center as determined by Landlord require Tenant: (a) (b) (c) [see Figure 4-8 above] [see Figure 4-9 above] to be open when to do so would violate any law, criminal or civil, or subject Tenant or its employees to a fine or penalty, whether criminal or civil in nature. 4.06 FAILURE OF THE COTENANCY REQUIREMENT 4.06 Failure of the Cotenancy Requirement. Tenant may not invoke its remedies (see 4.07 infra until the cotenancy requirements have failed. But it is not always clear when this occurs. What if the department stores or satellite stores open late or close early? What if they are closed for force majeure reasons or for remodeling or taking inventory? What if a department store has gone dark but has been replaced by someone else who does not occupy all of the space that was formerly occupied by the department store? PHL_A #1457546 v1 WORD97-10-
These are all legitimate concerns and should be addressed by the parties. Following is a sample clause: Figure 4-11 A store shall not be considered open for business if such store is open and operating less than (X) the designated days and hours, or (y) is operating in less than all of its space as set forth herein. Notwithstanding the foregoing, if the Operating Requirements are not being met because a store is closed by reason of casualty, condemnation or the making of repairs or alterations or the taking of inventory, such closure shall not give rise to any right of Tenant to pursue any of Tenant's Remedies unless such closure continues beyond a period of sixty (60) days following the occurrence. The landlord may want to provide for different grace period times for different situations. For example, a renovation or restoration of a department store will take longer than that of a satellite store. These differences ought to be recognized provided the tenant puts an ultimate limit on them. Although the real time it may take to complete these operations may often exceed those limits, the question the tenant must face is how long must he endure the cotenancy failure by reason of such occurrences, regardless of whether the closures are anyone's "fault". A provision such as the following would work: Figure 4-12 Notwithstanding the foregoing, the closure of any Department Store or Satellite Store by reason of the following causes shall not be deemed a cotenancy failure nor give rise to any right of Tenant to pursue any of Tenant's Remedies unless such closure continues beyond the periods hereinafter set forth: A. Fire or other casualty: Department Stores - 180 days; Satellite Stores - 60 days; B. Remodeling: Department Stores - 90 days; Satellite Stores - 60 days; C. Taking inventory: Department Stores - 10 days; Satellite Stores - 5 days; D. Force Majeure other than fire or other casualty: Department Stores - 30 days; Satellite Stores - 30 days. 4.07 TENANT'S REMEDIES IF COTENANCY REQUIREMENTS FAIL Once the cotenancy requirements have failed, there must be a method of relief available to the tenant to minimize his exposure to potential losses. Three remedies are generally employed: the right to go dark, the right to pay an alternate rent and the right to terminate the lease. Each is discussed below. PHL_A #1457546 v1 WORD97-11-
4.07-1. The Right To Go Dark. From a tenant's perspective, he did not bargain for the right to operate in the middle of a deserted project nor in one that is 50% empty. Rather, he bargained for, and his minimum rent is based upon, an environment of a collective of retailers who together create a synergism for their collective benefit. If the retail climate around him has decayed to a point such that his sales have fallen below profitable levels, he no longer enjoys that healthy environment originally bargained for. He must, of necessity, close. The following provision is an example of a clause which permits the tenant to close his store upon a failure of the operating requirements. Figure 4-13 Tenant Permitted to Close Store Tenant shall not be required to open the Premises for business at all nor to operate during designated days and hours unless the ABC department store plus stores other than the Premises and representing seventy-five percent (75%) of the total GLA of the Shopping Center (which total GLA includes the GLA of the Premises but excludes the GLA of the Department Stores) are operating during such designated days and hours. The aforementioned minimum co-tenancy requirements operating during the designated days and hours shall in combination be called the "Operating Requirements". If the Operating Requirements are not met at any time, then Tenant shall have no obligation to operate and may close the Premises during such period of time that such Operating Requirements are not being met. During such period of closure, Tenant shall pay, in lieu of all other Rent, additional rent and other charges hereunder, the Minimum Rent. (Emphasis added) Landlord's Grace Period. The landlord will complain, with justification, that it will take some time to replace the department stores or the satellite stores and that the tenant should wait for a period of time before electing one of his remedies. Usually they ask the tenant to wait at least one year. While it's true that it can take a year or longer to replace a department store (and perhaps 6 months to replace a satellite store), the question that the tenant must ask himself is whether he can afford to operate in the red for such a period. Typically, he cannot. Upon a failure of the operating requirements (whether because of a department store closure or a satellite store closure) he must be permitted to immediately go dark. As a compromise, a tenant might agree to a grace period before he elects to go dark, e. g. 3 months for satellite stores, 6 months for department stores. While it is acknowledged that this may not give the landlord sufficient time with which to replace the closed or violating store, it is intended only as an arbitrary grace period during which nothing bad will happen to him. Sales Tests. Many landlords take the view despite the failure of the cotenancy requirements, the tenant should not have the right to go dark (or exercise any other right for that matter) unless the tenant's sales are impacted by the closure, as reflected in a decline in his sales by a certain amount, e.g. ten percent (10%), which occurs within a proximate time thereafter. From the tenant's viewpoint, this argument is flawed. It is inappropriate for the landlord to require the tenant to justify his decision once the landlord has failed to maintain the cotenancy PHL_A #1457546 v1 WORD97-12-
requirements. The decision of whether to close will be made by the tenant in the exercise of its own economic self-interest and common sense. If the sales levels he is experiencing are still sufficient to operate profitably despite the cotenancy failure, he will stay open regardless of what the lease says or who is open around him. If sales are below profitable levels, he must close. His own profit motivation will decide that question for him, not some provision in the landlord's lease form. It must also be remembered that when the cotenancy requirements were being met, the tenant was required to operate whether his store was profitable or not. However, once there is a cotenancy failure he should have the right to close based on whether he can continue to operate profitably, a decision only he can make. Or, he may be entitled to receive rent relief (and ultimately the right to terminate) while he continues to operate in a substantially vacant center. Further, the tenant's sales may have been already bottomed out at the time of the cotenancy failure because of a continuing decline of his business resulting from a continuing decline of the center. By the time the cotenancy requirements finally fail he may not be able to demonstrate a further drop in sales. The landlord would then point out that this is proof that the tenant's poor business was due to other factors unrelated to the cotenancy failure and that there was no causal connection between the two. However, prior to the cotenancy failure, the tenant was required to be open despite the level of his sales. After the cotenancy failure, he is entitled to make the choice that will minimize his losses and not be sandbagged by his previous level of sales. Otherwise, the tenant who needs the relief the most will be penalized the hardest while other tenants who were operating at a higher level and can demonstrate a decline in sales would be entitled to such relief. Tenants will operate if they can make money; they will close if they cannot. Its not appropriate for the landlord to determine whether tenant's losses are sufficient to justify a closure. It must be remembered that in the clause illustrated in Figure 4-13 above, the tenant is not asking for the right to cease paying rent. He will continue to pay full minimum rent on the vacant space but he has cut his losses by eliminating the expenses of salaries, utility consumption and investment in merchandise for that store. Indeed, while the cotenancy requirements are being met but are at less than full operational levels-for example at 76% and minus one of the department stores -- the tenant is operating and paying a I 00% rental for a 76% center. In other words, the landlord has been given a contingency margin of up to 25%; also, one or more of the other department stores may have closed but the operating Requirements are still being met. If the cotenancies fall below even those levels the tenant will still have to pay the bargained-for minimum rent but at least he can close the store and limit his operational expenses and additional rent expenses. Simple Sales Test. Rather than require the tenant to demonstrate a sales decline immediately following the cotenancy failure, the parties might agree to set a certain sales threshold to determine the tenant's right to go dark. If the tenant's sales are above that threshold despite the cotenancy failure, then the tenant may not go dark so long as his sales remain above that threshold. If his sales are or eventually fall below the threshold while a continuous cotenancy failure is in progress, then the tenant may close. The threshold should be an aggressive one since the tenant is taking all of the risk here but it is not necessary that it be set PHL_A #1457546 v1 WORD97-13-
at the tenant's profit/loss breakeven point. It must be a simple gross sales threshold (the tenant should not have to disclose his profit and loss statement for the store) and should be sufficient to allow the tenant to determine whether any profit he is making is worth the effort. The tenant is in the best position to determine what that threshold should be. What Rent Should The Tenant Pay? Landlords insist that if the tenant does go dark, all rent other than percentage rent - i.e. minimum rent, common area maintenance charges, taxes, insurance, utilities, merchants' dues, etc. - must continue to be paid. From the tenant's viewpoint, the failure of the cotenancy requirements represent a decline in the rental value of the center and that must be reflected in a suspension of all charges other than the minimum rent (and presumably utility charges consumed at the premises). This is simply an economic decision which is negotiated. Landlord's Right to Terminate if Tenant is Dark Often a landlord will want the right to terminate the lease if the store is closed for a period of time. While this may not an be unwelcome result for the tenant, the tenant will want the landlord to reimburse him for the remaining undepreciated costs of the tenant improvements installed by the tenant at his expense (i.e., exclusive of any construction allowance received from the landlord). At that point, the landlord may wish to reconsider his cancellation if the cost is too high; he should be given the opportunity to do so. Tenant's Right to Reinstate Lease. On the other hand, the tenant may wish to preserve the lease if he is in the middle of negotiations for an assignment or sublease. Or, he may be willing to give the store another try, especially if the formerly empty spaces are being leased up but are not yet at the cotenancy threshold. Therefore, he will want the right to nullify the landlord's termination and reinstate the lease provided the tenant reopens within a specified period of time. The landlord may object to the reinstatement, however, if he has already made a deal with someone else while the tenant was closed; he should be permitted to pursue his other deal. The following clause embodies all of the foregoing concerns: Figure 4-14 Landlord's Right to Terminate for Closure. In the event Tenant remains closed for a continuous period of sixty (60) days, Landlord shall have the right, during the time the Premises is closed, to terminate this Lease on thirty (30) days notice to Tenant provided that Landlord pays to Tenant (the "Reimbursement") the amount of Tenant's Remaining Improvement Costs, calculated as of the effective date of termination. Within twenty (20) days after receipt of Landlord's termination notice, Tenant shall furnish to Landlord Tenant's statement, certified as correct by Tenant's Chief Financial Officer or the Controller of Tenant who shall be a CPA, of the amount of Tenant's Remaining Improvement Costs. The validity and effectiveness of Landlord's cancellation shall be conditioned upon the payment to Tenant of the Reimbursement within ten (10) days after submission by Tenant of its statement of Tenant's Remaining Improvement Costs. In the event, however, Tenant fails to furnish Landlord its statement of Tenant's Remaining Improvement Costs within the twenty (20) day PHL_A #1457546 v1 WORD97-14-
period aforesaid, the requirement of Landlord to pay the reimbursement shall be deemed waived by Tenant. Landlord's Right to Rescind Cancellation. Within a period of ten (10) days following receipt of Tenant's statement of the Remaining Improvement Costs, Landlord shall have the right to withdraw its termination notice and to reinstate this Lease. Tenant's Right to Reinstate. Notwithstanding the foregoing, Tenant shall have the right to nullify Landlord's termination and to reinstate this Lease by notifying Landlord (the "Reinstatement Notice"), within ten (10) days after receipt of Landlord's notice, that Tenant intends to reopen the Premises for business within sixty (60) days thereafter and to resume payment of either the Minimum Rent or the Alternate Rent, whichever was in effect at the time Tenant elected the Right to Close Remedy. The validity and effectiveness of Tenant's reinstatement shall be conditioned upon Tenant's actual opening of the Premises and the resumption of the applicable rent within the sixty (60) day period aforesaid. Landlord's Right to Nullify Tenant's Reinstatement. If Tenant elects to reinstate this Lease, Landlord shall have the right, for a period of ten (10) days following receipt of the Reinstatement Notice, to notify Tenant that it has signed a lease with another tenant for the Premises, as evidenced by a fully executed copy thereof between Landlord and such other tenant. In such event, Tenant's reinstatement of this Lease shall be ineffective and the term hereof shall expire upon the original termination date specified in Landlord's cancellation notice. Tenant's Rights After Reinstatement. Many landlords take the position that once the tenant makes the decision to reinstate, he waives all cotenancy protection forever after. This is too harsh and unfair. Tenant's decision to reinstate is based on a business decision he is making predicated on how things are at that moment in time. If he does reopen, it is most likely based upon the fact that he now feels he can operate profitably and is willing to give it another try. He should not be penalized for this. It is appropriate however, to limit his rights in some fashion for the immediate future to prevent an endless cycle of closings, terminations and reinstatement. An acceptable clause would be an obligation of tenant to operate and pay full minimum rent for a year from the reinstatement regardless of any cotenancy failure, with the tenant to have his full panoply of remedies thereafter for the then existing or any new cotenancy failure. Further, if he closed again and the landlord again terminated the lease, the tenant's right to reinstate would be eliminated. However, if the cotenancy failure is cured and subsequently fails again later on, the tenant would once again have all of his rights and remedies, including the right to reinstate the lease if it were terminated by the landlord by reason of the tenant's Closure. 4.07-2. Straight Percentage Rent In Lieu of Going Dark. Landlords frequently offer to allow the tenant to simply convert to a straight percentage rent upon a cotenancy failure but forbid the PHL_A #1457546 v1 WORD97-15-
tenant the right to go dark. From a tenant's perspective such a gesture may be of little value if he is having a $100 day. The fact that his rent expense for that day has been reduced to $5 does not compensate for his high operating costs. When the tenant is operating in the red, the savings in rent may just not be worth it. It is better for the tenant to have the choice in this matter - i.e. either to go dark and pay minimum rent or to stay open and pay straight percentage rent. Sometimes sales may be adversely affected by the closure of the other stores but still have not reached an unprofitable level. It may the behoove tenant to stay open and go on straight percentage rent. This would protect him against further declines in sales until they reached the point where he would want to go dark and simply pay minimum rent. Thus, the conversion to straight percentage rent with no minimum guarantee, even where the tenant's sales are still acceptable, is the price the landlord must pay to have the tenant stay open despite the failure of the operating requirements. Landlord's Argument. Other landlords take the view that if the tenant elects to remain open and operate, he should continue to pay the minimum rent. This argument is also untenable. If the tenant's sales had been below the percentage rent breakpoint or were even below his profitability level while the cotenancies were being met, the tenant was required to operate and pay the minimum rent. However, if the landlord has failed to hold up his end of the bargain and the cotenancies have failed, then if the tenant elects to remain open, the landlord must share the risks with him. If the tenant's sales were above the breakpoint at the time of the cotenancy failure and continue above that level, the landlord continues to receive exactly the rent that he bargained for. However, if the tenant's sales were below the breakpoint at the time of the failure or fall below the breakpoint thereafter, then its only fair that the tenant pay a percentage of his sales rather than a guaranteed minimum amount. This is an issue of diminished rental value of the premises when the cotenancy requirements have failed. Since the tenant is undertaking much of the risk by choosing to remain open despite the cotenancy failure, he should not continue to be obligated to pay the minimum rent nor the additional rents for that matter. Otherwise, the landlord gets the full benefit of his bargain regardless of a cotenancy failure and the tenant may or may not depending on how well he does. This is unfair. Straight Percentage Rent With a Cap On the other hand, tenants typically stipulate that if they choose to remain open despite a cotenancy failure, they will pay the lower of a percentage of its sales or the minimum rent. Landlords argue that it is the tenant who now seeks to reap the best of both worlds, completely protecting his downside but limiting the landlord's potential upside by stating that he will never pay more than the minimum rent - even if his sales remain high - but he may pay less. Again, it is an issue of diminished rental value of the space rather than a question of how well the tenant is doing. If the tenant continues to take the risk and operate despite the cotenancy failure, then he exposure should be capped. If the tenant is doing well, the landlord will at least receive the minimum rent; the percentage rent was always contingent in nature and was never guaranteed, even when the cotenancy requirements were being met. Sales Test. As in the case where the tenant seeks to close the store, landlords try to impose a sales test upon the tenant as a precondition to its right to switch to the a straight percentage rent. The discussion above regarding a sales test in the context of a decision to go dark is equally applicable here. PHL_A #1457546 v1 WORD97-16-
Figure 4-15 Tenant May Close or Pay Percentage Rent In the event that the Operating Requirements are not being met, then effective immediately, Tenant shall have the following rights: (a) (b) Right to Close. To immediately close the Premises for business and during such period of closure Tenant shall continue to pay the Minimum Rent in lieu of all other rent payable hereunder and Tenant will perform all of such other obligations as are applicable to a vacant premises. This remedy shall be referred to as the "Right to Close Remedy." Alternate Rent. To remain open for business but effective immediately, to pay monthly, as alternative rent (the "Alternate Rent"), during the period that there is a Cotenancy Failure, in lieu of Minimum Rent and Percentage Rent (computed in the manner set forth in this Lease) an amount equal to the lower of (i) percent( %)of all Gross Sales (as defined herein) made in the Premises for each month (or portion thereof) during such period, or (ii) the monthly amount of Minimum Rent. Each such payment of the Alternative Rent shall be made within thirty (30) days after the end of each month (except that the utilities portion shall be paid when due, if other than monthly) and shall be accompanied by Tenant's statement of Gross Sales made during the previous month. This remedy shall be referred to as the "Alternative Rent Remedy." Landlord's Grace Period. As in the case of Tenant's right to go dark, the landlord will complain, with equal justification, that it will take time to replace the department stores or the satellite stores and that he should be given a grace period before the tenant can elect one of its remedies. However, unlike the case of the right to go dark, the tenant must be permitted to immediately convert to percentage rent. 4.07-3. Tenant's Right to Terminate the Lease. At some point in time the tenant must have the right to terminate the lease if the operating requirements have failed for an extended period. Consistent with the paragraph immediately preceding, he can agree to a grace period before he is entitled to terminate the lease. Figure 4-16 Tenant's Right to Terminate In the event the operating Requirement have not been met for a continuous period of six (6) months, in the case of the Department Stores, or for three (3) months in the case of the Satellite Stores, then in addition to the Right to Close Remedy and the Alternative Rent Remedy, Tenant shall have the PHL_A #1457546 v1 WORD97-17-
continuing right thereafter and while such Cotenancy Failure continues, to cancel and terminate this Lease upon thirty (30) days notice to Landlord. The remedy described herein shall be referred to as the "Termination Remedy." Once such Termination Remedy has been exercised by Tenant, Tenant's cancellation shall not be affected or nullified by the fact that the Operating Requirements have once again been met during the thirty (30) day cancellation notice period unless Tenant, in its sole discretion, elects to revoke its cancellation notice and reinstate this Lease. Tenant Must Choose. Some landlords attempt to require the tenant to make the decision to terminate within a limited period of time or otherwise waive his rights altogether. If the tenant elects to remain, then, the landlord argues, the tenant must operate, pay full minimum rent and waive all of his cotenancy protection forever after. This is too harsh of a result. While the negative effect of the cotenancy failure has been hurting the tenant's sales, they may still be at marginal profitable levels. He just may not be ready to make such an irrevocable, draconian choice at that time. It may be that later on the effect of the cotenancy failure will worsen and drive his sales below the profitable level. The tenant must simply wait and see. However, the landlord may have a legitimate concern in avoiding the uncertainty of not knowing from one moment to the next whether he is going to have a lease or not. In such a dilemma he is unable to make arrangements to find a replacement for the tenant's space. As a compromise, the tenant might agree that if he decides to stay, he will operate and pay full minimum rent for another year, regardless of the cotenancy failure. If at the end of that year there has been a continuous cotenancy failure during the interim, then the tenant gets to make the same election again. This process would be repeated thereafter on an annual basis assuming that there has been a continuous cotenancy failure all along. 6 4.08 LANDLORD'S REMEDIES IF TENANT VIOLATES COVENANT Remedies for Violations of Operating Covenants A breach of the operating covenant contained in the lease constitutes a material breach of the terms of the lease, entitling a landlord to exercise all of its rights under the lease and at law to terminate the lease and regain possession. As noted below, injunctive relief for failure to operate may also be available in certain states. Providing for an additional remedy, such as the liquidated damages payment contained in Figure 4-18 below, may be important to address situations where the termination of the lease for default is too drastic a remedy in the case of a tenant who is otherwise a productive part of the shopping center but refuses to operate during shopping center hours. The liquidated damages provision may be preferable to injunctive relief because it can be invoked 6 Of course, if the cotenancy requirements are once again met at any time during this period, the chain is broken and the tenant must operate and pay full minimum rent. Upon a subsequent cotenancy failure, the whole process starts all over again: (1) the tenant may pursue his three remedies, (2) after the requisite waiting period, he may elect to cancel or to remain and is afforded the annual review cycles thereafter. PHL_A #1457546 v1 WORD97-18-